Contribution margin ratio
Contribution margin ratio measures the percentage of sales that would increase net income. It can be calculated by dividing the contribution margin by sales, either[1]:
- in total
- per unit.
The contribution margin ratio is most useful when the increase or decrease in sales volume is measured in sales dollars. In this case, the change in sales dollars multiplied by the contribution margin ratio equals the change in income from operations[2]. The contribution margin should be relatively high, as it should be sufficient to cover both fixed and operating overhead expenses. If the contribution margin ratio is excessively low or negative, continuing to sell a product at that price point would be unwise, as the company would have considerable difficulty in earning a long-term profit. Nevertheless, there are situations where it may be reasonable to sell a bundle of goods and/or services where there is a negative contribution margin for individual items in the package, as long as the contribution margin for the package is positive. The ratio is also useful in determining the revenue from different sales rates.
Formula of the Contribution Margin Ratio
The formula of the Contribution Margin Ratio is presented as [3]:
Contribution Margin Ratio in Strategies of Developing Business
Also useful in developing business strategies is the contribution margin ratio. Assume, for example, that a company has a high contribution margin ratio and produces less than 100 percent of capacity. In this scenario, from an increase in sales size, a significant increase in revenue from operations can be expected. The company could consider carrying out a special sales campaign to increase sales. On the other hand, a business with a low contribution margin ratio would likely want to pay more attention to cost management before trying to promote sales[4].
Examples of Contribution margin ratio
- Contribution margin ratio is used to find the profitability of a single product or a group of products. For example, a company that produces and sells five different products can use the contribution margin ratio to determine which products are the most profitable. The company can subtract the variable costs associated with each product from the sales and then divide the contribution margins by the sales to calculate the contribution margin ratio.
- Contribution margin ratio can also be used to determine the overall profitability of the company. For example, a company may want to know what percentage of their revenue is contributing to their bottom line. By calculating the contribution margin ratio, they can determine the percentage of their sales that is actually translating into a profit.
- Contribution margin ratio can also be used to determine the break-even point for a business. This is the point at which the company's costs equal their revenue, and the contribution margin ratio is the percentage of revenue that is contributing to that break-even point.
- Moreover, contribution margin ratio is used to determine the impact of a price change on a company's revenue. For example, a company may want to know what the impact of a price increase on a particular product would be. By using the contribution margin ratio, they can determine the percentage of revenue that would be affected by the price increase. This can help them decide whether or not the price increase would be beneficial for the company.
Advantages of Contribution margin ratio
Contribution margin ratio provides a useful tool to measure the profitability of a business. It has a number of advantages, including:
- It helps to identify the products or services with the highest contribution margin ratio and thus, which products or services are the most profitable.
- Contribution margin ratio helps to determine the breakeven point of a business by analyzing the relationship between fixed costs and variable costs.
- It can be used to gain insight into pricing strategies and determine the optimal pricing for products and services.
- It is also useful for making decisions on whether to accept a special order and for evaluating profitability of different investments.
- The contribution margin ratio also provides a measure of the company's ability to cover fixed costs.
Limitations of Contribution margin ratio
The contribution margin ratio is a useful tool for evaluating a company's profitability, but it has several limitations. These include:
- It ignores fixed costs, such as rent, salaries, taxes and other overhead expenses. This means the ratio may not accurately reflect the actual profitability of a business.
- It does not take into account any non-quantifiable factors such as customer service or brand recognition.
- It does not consider the potential impact of changes in the market or other external factors.
- It does not provide an accurate estimate of a company's cash flow.
- It does not provide information about the sustainability of a company's profits over time.
Contribution margin ratio is an important measure of profitability and can be calculated in several different ways. Other approaches related to contribution margin ratio include:
- Variable Cost Ratio: This ratio measures the portion of sales that is attributable to variable costs. It is calculated by dividing variable costs by sales.
- Fixed Cost Ratio: This ratio measures the portion of sales that is attributable to fixed costs. It is calculated by dividing fixed costs by sales.
- Contribution Margin Per Unit: This ratio measures the portion of sales that is attributable to the contribution margin per unit. It is calculated by dividing the contribution margin per unit by the selling price per unit.
- Operating Leverage Ratio: This ratio measures the portion of sales that is attributable to operating leverage. It is calculated by dividing the contribution margin by the operating leverage.
In summary, the contribution margin ratio measures the percentage of sales that would increase net income and can be calculated using several different approaches.
| Contribution margin ratio — recommended articles |
| Cost-income ratio — Combined Ratio — Economic income — Differential cost — Contribution to sales ratio — Gross margin in retail industry — Return on sales — Point elasticity — Activity ratios |
References
- Albrecht W., Stice J., Stice E., Swain M., (2007)., Accounting: Concepts and Applications, United States of America
- Davis C. E., Davis E. B., (2010)., Managerial Accounting for Strategic Decision Making, Preliminary Edition, John Wiley & Sons, United States of America
- Heisinger K., (2009)., Essentials of Managerial Accounting, Cengage Learning, United States of America
- Holtzman M. P., (2013)., Managerial Accounting For Dummies, John Wiley & Sons, United States of America
- Reeve J., Warren C., Duchac J., (2011)., Accounting Using Excel for Success, Cengage Learning, United States of America
- Warren C., Reeve J., (2006)., Managerial Accounting, Cengage Learning, United States of America
Footnotes
Author: Aleksandra Walawska
